Preferred share fixed-income funds are on a roll these days, after a
calamitous 2015. The average return for the 13-fund category for the
one-year period ended July 31, 2017, was a healthy 16.1%, compared with
-11.93% for calendar year 2015. Of course, 2015 was bad for equities as
well (the overall Canadian Equity category averaged -6.8% for that year,
but is up 5.8% for the year through the end of July 2017). But the reasons
for the two turnarounds were largely unrelated, according to Jeff Herold, co-manager (with Dax Letham and Ian Clare) of Toronto-based J. Zechner Associates, which sub-advises
NGAM Canada’s
Natixis Canadian Preferred Share Fund (NGAM is an affiliate of Natixis Global Asset Management SA in Paris,
France).

The Canadian equity tumble was a not entirely unexpected correction. The
S&P/TSX Composite fell from 15,234 on February 2015 to 12,822 by the
end of the year, ending a bull market that had risen all the way from 8,123
in February 2009 (it has moved back above the 15,000 mark in recent
months). The preferred share “hiccup,” on the other hand, was a
fixed-income issue related to interest rate trends and expectations.

“In 2015, people were worried that forthcoming rate resets would push
dividend rates lower on preferred shares if they bought them at that time,”
says Herold. “So why not wait and buy them later?” He adds by way of
explanation that originally preferred share dividend rates were fixed for
the duration (“perpetuals”), but most now undergo “rate resets” every five
years to more closely align dividend rates with prevailing interest rates.
“Seventy to 80% of the market now is resets,” he says.

So, for example, if the prime rate is 2% and the dividend is 5%, and the
interest rate moves to 2.5%, the dividend is reset at 5.5%; if the interest
rate moves to 1% the dividend is reset at 4%. But this feature makes them
much more sensitive to interest rate changes and expectations. And because
preferred shares have no maturity date, resets can exhibit the same
magnified volatility as very-long-term bonds.

“In 2015 the interest rate fell and the spread was quite narrow, so some
[reset rates] dropped by 50%, although perpetuals dropped only 2%,” Herold
recalls. He adds that his fund weathered the storm better than most because
of a 70% allocation in perpetuals as well as a high cash position going
into 2015, resulting in a 3-year average annual compounded rate of return
of 2.9% through the end of July, compared with the category average of
1.8%. “We will use cash for defensive purposes, and can buy up to 40% in
bonds and cash equivalents, although the highest we got was 18%.”

Now, however, with interest rates on an upward trajectory, investor
interest and anticipation is building. “Investors believe that when there’s
another reset, they’re going to get better rates going forward,” says
Herold. “People are more optimistic, and demand is driving prices up.”

Meanwhile, his team is prepared on the upside. “As active managers, we can
take better advantage of market inefficiencies than ETFs [exchange traded
funds], since the preferred share market is not as liquid as the bond and
equity markets,” says Herold. Active management also enables the fund to
better seek value in a market that can be affected by rate resets as well
as spreads, call dates, and the potential for new issues, which can have a
depressing effect as investors await newly issued rates.

“We’re also better diversified – that’s another way we reduce risk,” Herold
adds. “We limit issuers to 5% of total assets, so our top five holdings
represent 23% to 25% of total assets, compared with as much as 36% in ETFs
that are based on the benchmarks. That matters, because some issuers can
have as many as 15 or 20 preferred shares, all affected the same way by
market or corporate changes. He cites the example of
Enbridge Inc. (TSX: ENB), whose multiple preferred shares were all downgraded recently as a result
of restructuring.

In addition, the fund has been shifting its focus from perpetuals to resets
that respond better to rate increases. “We were over 70% in perpetuals, but
now we’re at 60% resets,” says Herold.

“We’re positive about the longer-term outlook for preferreds,” Herold
concludes. “Bond yields are still low, and more and more fixed income
investors are looking to help those yields by adding preferreds. And we
think this demand will continue to grow, because while interest rates are
starting to move upward, bond yields will not rise dramatically – it will
be more of a slow increase.”

Olev Edur is an experienced financial and business journalist and a frequent
contributor to the Fund Library.

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